INTRODUCTION TO

FINANCIAL FUTURES
MARKETS
CHAPTER 10
Emre Dlgerolu
Yasin te
Rahmi zdemir
Kaan Soanc

 Our purpose in this chapter is to

provide an introduction to financial
futures contracts, how they are
priced, and how they can be used for
hedging.

What a futures contract is?

A futures contract is an agreement that requires a party
to the agreement either to buy or sell something at a
designated future date at a predetermined price.
Futures contracts are categorized as either commodity
futures or financial futures. Commodity futures involve
traditional agricultural commodities (such as grain and
livestock), imported foodstuffs (such as coffee, cocoa, and
sugar), and industrial commodities. Futures contracts based
on a financial instrument or a financial index are known as
financial futures. Financial futures can be classified as
(1) stock index futures
(2) interest rate futures
(3) currency futures.

who do you use futures contracts

markets?
1. Hedgers
2. Speculators
3. Brokers

MECHANICS OF FUTURES TRADING

A futures contract is a firm legal agreement
between a buyer and an established exchange or
its clearinghouse in which the buyer agrees to
take delivery of something at a specified price at
the end of a designated period of time. The price
at which the parties agree to transact in the
future is called the futures price. The designated
date at which the parties must transact is called
the settlement date.

LIQUIDATING A POSITION
Most financial futures contracts have settlement
dates in the months of March, June, September, or
December.
The contract with the closest settlement date is
called the nearby futures contract.
The contract farthest away in time from the
settlement is called the most distant futures
contract.
A party to a futures contract has two choices on
liquidation of the position.
First, the position can be liquidated prior to
the settlement date.
The alternative is to wait until the settlement
date.

Clearinghouse
A clearinghouse is agency associated with an
exchange, which settles trades and regulates
delivery.

THE ROLE OF THE CLEARINGHOUSE

Associated with every futures exchange is a
clearinghouse, which performs several functions,
one of these functions is
guaranteeing that the two parties to the
transaction will perform.
Besides its guarantee function, the clearinghouse
makes it simple for parties to a futures contract to
unwind their positions prior to the settlement
date.

MARGIN REQUIREMENTS
When a position is first taken in a futures contract,
the investor must deposit a minimum dollar
amount per contract as specified by the exchange.
Three kinds of margins specified by the exchange:
1) initial margin (may be an interestbearing security such as a Treasury bill, cash, or
line of credit)
2) maintenance margin (specified by the
exchange)
3) variation margin (additional margin to
bring it back to the initial margin if the equity falls
below the maintenance margin, must be in cash).

MARKET STRUCTURE
On the exchange floor, each futures contract is
traded at a designated location in a polygonal or
circular platform called a pit. The price of a
futures contract is determined by open outcry of
bids and offers in an auction market.
Floor traders include two types: locals and floor
brokers.

Daily Price Limits

The exchange has the right to impose a limit on
the daily price movement of a futures contract
from the previous session's closing price.

FUTURES VERSUS FORWARD

CONTRACTS
A forward contract, just like a futures contract, is
an agreement for the future delivery of something
at a specified price at the end of a designated
period of time.

Futures contracts

Forward contracts

Standardized contract
(delivery date,
quality, quantity)

yes

no

Where to be traded
(primary market)

organized exchanges

over-the-counter
instrument

Credit risk (default risk)

no

yes

Clearinghouse

yes

no

Settlement

marked-to-market
(daily)

end of the contract

Margin requirement

yes

no

Transaction cost

low

high

Regulations

yes

no

RISK AND RETURN

CHARACTERISTICS OF FUTURES
CONTRACTS
Long futures: An investor whose opening
position is the purchase of a futures contract

Short futures: An investor whose opening

position is the sale of a futures contract.
The long will realize a profit if the futures price
increases.
The short will realize a profit if the futures price
decreases.

Pricing of futures contracts

To understand what determines the futures price, consider
once again the futures contract where the underlying
instrument is Asset XYZ. The following assumptions will be
made:
1. In the cash market Asset XYZ is selling for $100.
2. Asset XYZ pays the holder (with certainty) $12 per year in
four quarterly payments of $3, and the next quarterly
payment is exactly 3 months from now.
3. The futures contract requires delivery 3 months from now.
4. The current 3-month interest rate at which funds can be
loaned or borrowed is 8% per year.
What should the price of this futures contract be?
That is, what should the futures price be? Suppose the
price of the futures contract is $107. Consider this
strategy:
Sell the futures contract at $107.
Purchase Asset XYZ in the cash market for $100.
Borrow $100 for 3 months at 8% per year.

1. From Settlement of the Futures Contract

Proceeds from sale of Asset XYZ to settle the
futures contract
Payment received from investing in Asset XYZ
for 3 months
$3
Total proceeds
$110
2. From the Loan
Repayment of principal of loan
$ 100
Interest on loan (2% for 3 months)
Total outlay
= $102
Profit
8

= $107
=
=

=
=

= $

Theoretical Futures Price Based On

Arbitrage Model
We see that the theoretical futures price can be determined
based on the following information:
1. The price of the asset in the cash market.($ 100)
2. The cash yield earned on the asset until the settlement date.
In our example, the cash yield on Asset XYZ is $3 on a $100
investment or 3% quarterly (12% annual cash yield).
3. The interest rate for borrowing and lending until the
settlement date. The borrowing and lending rate is referred
to as the financing cost. In our example, the financing cost is
2% for the 3 months.
We will assign the following:
r = financing cost
y = cash yield
P = cash market price ($)
F = futures price ($)

 The theoretical futures price ;

F =P+P(r-y)
Our previous example to determine the
theoretical futures price ;
r= 00.2
y= 00.3
P= $ 100

Then , the theoretical futures prises is:

F= $ 100 + $ 100 ( 0.02 0.03 )
F= $ 100 - $ 1
F= $ 99

Difference Between Lending and

Borrowing Rate
The borrowing rate is greater than the lending
rate.
Letting;
rB = borrowing rate
rL = lending rate
F = P + p(rB-y)
F = P + p(rL-y)

 For example, assume that the borrowing rate is

8% per year, or 2% for 3 months, while the
lending rate is 6% per year, or 1.5% for 3 months.
The upper boundary and lower boundary for the
theoretical futures price is:
F(upper boundary) = $100 + $100(0.02 - 0.03)
= $ 99
F(lower boudary) = $100 + $100(0.015 - 0.03)
= $ 98.50

General Principles of Hedging With

Futures
The major function of futures markets is to transfer
price risk from hedgers to speculators. That is, risk
is transferred from those willing to pay to avoid risk
to those wanting to assume the risk in the hope of
gain. Hedging in this case is the employment of a
futures transaction as a temporary substitute for a
transaction to be made in the cash market. The
hedge position locks in a value for the cash
position. As long as cash and futures prices move
together, any loss realized on one position (whether
cash or futures) will be offset by a profit on the
other position. When the profit and loss are equal,
the hedge is called a perfect hedge.

Risk Associated with Hedging

The term r - y, which reflects the difference
between the cost of financing and the asset's
cash yield, is called the net financing cost. The
net financing cost is more commonly called the
cost of carry or, simply, carry.

The amount of the loss or profit on a hedge will be

determined by the relationship between the cash
price and the futures price when a hedge is
placed and when it is lifted. The difference
between the cash price and the futures price is
called the basis.
That is, basis = cash price - futures price
if a futures contract is priced according to its
theoretical value, the difference between the
cash price and the futures price should be equal
to the cost of carry. The risk that the hedger takes
is that the basis will change, called basis risk.

Cross-hedging
Cross-hedging is common in asset/liability and
portfolio management because no futures contracts
are available on specific common stock shares and
bonds. Cross-hedging introduces another riskthe risk
that the price movement of the underlying instrument
of the futures contract may not accurately track the
price movement of the portfolio or financial instrument
to be hedged. It is called cross-hedging risk.
Therefore, the effectiveness of a cross-hedge will be
determined by:
1.
The relationship between the cash price of
the underlying instrument and its futures price when a
hedge is placed and when it is lifted.
2.
The relationship between the market (cash)
value of the portfolio and the cash price of the
instrument underlying the futures contract when the
hedge is placed and when it is lifted.

Long Hedge Versus Short Hedge

A short (or sell) hedge is used to protect against

a decline in the future cash price of a financial
instrument or portfolio.
To execute a short hedge, the hedger sells a
futures contract (agrees to make delivery).
A long (or buy) hedge is undertaken to protect
against an increase in the price of a financial
instrument or portfolio to be purchased in the
cash market at some future time.

 Thank you for listening,